What is Block trade and how does it work

What does a block trade mean?

Block trade involves two parties who trade a considerably large number of bonds and equity at a pre-decided price. Many times, investors choose to carry out such trades in order to be safe from price cuts as this allows them to reach a consensus on the price that works in the favour of the seller. Typically block trades are organized separately from the public markets so that the impact on the security’s price is low.

Hedge funds or institutional investors are the ones who usually carry out block trades. They do so vis-a-vis investment banks and other intermediaries. However, those investors whose high net worth has been accredited could also be eligible to take part.

As a commonly observed rule, a minimum amount for a block trade is 10,000 securities which do not include penny stocks or bonds worth $200,000. However, in reality, block trade would have well over 10,000 shares.

Understanding block trade

In general, if there is a huge order placed via the stock market, it could affect the share prices. On the other hand, a block trade that has been negotiated privately would come with its own set of discounts on the market rate. Other participants in the market would not be aware of the additional supply till the time there is a public record of the transaction.

Undisclosed block trades are material non-public information. FINRA, the self-regulatory authority of the financial world, does not allow revealing such information in advance. Block trades are done through specialized intermediaries such as block trading facilities and blockhouses. Block houses are basically departments that work within trading companies and run dark pools as well as private exchanges where large size buy and sell orders are matched away from the public view. Block houses may even place something like a number of iceberg orders so that large trades on the public market are broken. Such acts conceal the scope of additional supply.

How does block trade work?

To understand how block trade works, let’s look at the scenario below:

A hedge fund owns 100,000 shares of a small-cap firm and wants to sell them at $10 which is also close to the present market rate. Since we’re looking at a potential million-dollar transaction for the shares of a firm that itself has a net worth of a few hundred millions, if the sale is conducted as a single market order, it would slash the price considerably. Additionally, the order’s size implies that by the time it is executed, the prices would only worsen once the demand is exhausted at the ask price of $10. Hence, the hedge fund could face slippage and there may be more market participants than expected who’d then begin to short the stock. It would typically end up pushing the price down further.

In order to avoid such an unfavourable situation, the hedge fund could reach out to a block house. At the blockhouse, the staff would first divide the big trade into several dealable sizes. For instance, they may cut down the block trade into 50 offers, each being of 2,000 shares. As each offer is shared by a different trading company, the origin becomes even more ambiguous. Another possible alternative is that the trading company gets an institutional investor who is keen on buying all 100,000 shares at the arranged price.

Advantages

• It is beneficial as it lets trade analysts see and observe where the stock pricing is done by institutional investors.

• It is particularly useful if there is a merger or an acquisition on the cards. The bid would then need a ‘clear market’ which would make the prices at which the large stock blocks are traded public. It also indicates the price at which the largest shareholders of a company would sell their personal shares. Hence, in block trading analysis, small trades are taken into consideration so as to avoid data skewing.

Disadvantages

• Block trade is harder than other trades as the trading company/agent commits to a particular rate. An unprecedented movement in the market that could affect multiple securities could upset the arrangement and thus cause losses. Hence, block trading may end in a tie-up between the trading company and the trading party’s funds.

• There could be a scenario where the big, well-informed money managers wish to purchase or sell a relatively large position of a certain stock. Such a case often indicates future price movements by performing a completely contrasting transaction of the trading company and the trading party. The money managers would be at an advantage as they have access to more information while at the same time, the agent-party duo would need to deal with selection risk.

Key Points to Remember:

• Block trade should always be conducted privately via chat, calls, or through any electronic mode. As the transaction is always direct between the two parties or the trading company, it is executed away from the public market.

• Blockhouses are generally the intermediaries responsible for carrying out block trade. These companies have expertise in large businesses and have a thorough knowledge of block trade. They understand the nuances of the transaction and thus, they carry it out with great care to ensure the price of shares or bonds does not dramatically rise or fall.

• Since these trades are enormous in size, when it comes to the equity or debt markets, it is hard to find any individual traders who carry out block trades. Typically, they are carried out by large-scale institutional investors and the hedge funds are responsible for buying and selling a large number of shares as well as bonds through intermediaries.

• If block trades are conducted in the open market, traders must exercise great caution as the size of the order could cause a lot of fluctuations in the transaction volume. It could also have some impact on the bonds’ or shares’ overall market value.

• As a result, block trades are carried out usually via intermediaries like a block house instead of an investment bank or hedge funds that buy securities as usual. If it were not for these intermediaries, these securities would continue to be bought or sold in smaller amounts only.